Problems with ZIRP (Friday, May 21, 2010)

ZIRP stands for Zero Interest Rate Policy. It refers to actions taken by one or more central banks. It can enhance near-term profitability or financial condition for financial institutions notably banks because it enables the larger institutions the capacity to borrow at zero or near zero. Since banks and other financial institutions can prosper by borrowing cheaply and lending dearly they can capture a spread or net interest margin. However, ZIRP has a serious dark-side.
The dark-side is when interest rates go up. These financial institutions may adjust their lending rates by having variable spreads or other conditions. Nevertheless the ever-present, lurking danger is that holdings may be materially impaired in terms of price. In other words, valuations can drop precipitously.
Although accounting standards have been changed to deal with mark-to-market issues a real impact of ZIRP is on Treasuries. Treasury securities are vital for monetary and fiscal policies. They are the underpinnings for yield curves. Treasuries are key investments for many commercial and investment banks, pensions, insurance companies, endowments, money market and bond funds among other holders.
Treasuries are issued with a fixed coupon, inflation adjustable rate (TIPS), or discount rate for short-term securities such as “treasury bills.” The interesting thing is that extremely low coupons effectively trade as approximations of zero coupon issues. In other words, the price sensitivity is very high to changes in the yield curve. To get an intuitive grasp of this major issue consider the following. If a $1,000 bond had a fixed coupon of 1 percent and no-or-perpetual maturity the bond would remain at $1,000 and generate interest income of $10 per annum. However, if interest rates increased to 2 percent then that same bond would lose half of its value. This drop in valuation is to adjust the fixed cash flow to the new interest rate reality. Continuing with the example, a new $1,000 bond issued at 2 percent would generate $20 per year income. For the outstanding one-percent bonds to generate prevailing $20 interest income you would have to buy 2 bonds paying 1 percent at $500 each.
Japan is stuck in that corner and other countries are too. This principal applies to other securities and instruments as well. The danger is even slight upward changes in interest rates can cause large losses for these securities that need mark-to-market price discovery. The upshot is financial institutions and other investors can be leveraged. This means that gains or losses can be magnified.
Where it really hits home is against leveraged regulatory capital. That means banks and mortgage companies must lend less, insurance companies will experience constraints on underwriting and other institutions will have to do less because they have less even in relatively low rate environment. The effects are across the board. It a matter of degree whether you are a consumer, supplier or regulator.
The bottom line is that ZIRP can be more difficult to leave than to enter.